Archive for August, 2012

Spurred by the burgeoning derivatives markets, in 1985 bankers invented Libor based on the London Interbank Offered Rates for the relevant currencies and periods. The actual offered rates vary according to the credit rating of the borrowing bank.

The British Bankers Association selected panels of banks for each currency – 16 for sterling comprising the main High Street banks and 11 overseas banks active in the London market. These report their perception of what the cost of funds to them would be in the Interbank market at 11am each business day. The highest and lowest quartiles are disregarded and the average of the rates perceived to be offered to the remaining panel members become Libor for that day. This system worked well for two decades and acquired world wide recognition.

The Banking Crisis

When the Banking Crisis struck in late 2007, banks ceased to lend on the Interbank market in an orderly way. HMG and the Bank of England came to the rescue of the Royal Bank of Scotland, Lloyds Banking Group and others. The rescued banks became flush with funds (which for reasons best known to themselves, they hoarded and failed to lend out to the struggling businesses which needed their support).

Being flush with funds, the rescued banks did not need funding from the Interbank market. However, Libor continued to be announced to prevent chaos in the derivatives markets. But how to calculate it when the market knew that major panel members would not be borrowing – their other sources of funding being cheaper.

Panel members in that position should simply have declined to quote but felt obliged to estimate what the cost of funds to them would be in the Interbank market – a purely theoretical exercise. Once this occurred, some individuals saw the possibility of manipulating the rates they quoted. Borrowers will have benefited by paying lower rates, but those gambling with derivatives have chosen the wrong casino!

Suggested Reforms

1. Substitute the actual rate (if any) last paid by each panel member that morning before 11am on a standard trade for its perception of what the cost of funds would be. If fewer than eight panel members can so report, Libor should remain unchanged until eventually suspended.

2. The computation of Libor plainly requires to be overseen by the Bank of England empowered to disqualify those who falsify their returns.

James Lingard

James Lingard is a retired partner in Norton Rose who specialised in banking and insolvency law. He was Chairman of the Banking Law Sub Committee of the City of London Law Society and the original author of Lingard’s Bank Security Documents now in its 5th edition(LexisNexis) and Bankers to Bankruptcy (Kindle/M-Y ebooks).